The Basics of Bank Loans

Christine Benz: Hi. I’m Christine Benz for Morningstar.com. Bank-loan funds have grown by leaps and bounds in recent years, but the securities may still be unfamiliar to some investors. I recently sat down with two of Morningstar’s bank-loan fund specialists, Sarah Bush and Tim Strauts, for an overview of the group.

I’d like to start with the basics here, let's talk about what bank loans are. Sarah, maybe you can take this one. Talk about what bank loans are and how they differ from bonds?

Sarah Bush: Bank loans are what they sound like. They’re loans made to companies to help them finance mergers and acquisitions or sometimes for refinancing purposes. Typically, they’re made to a company, and then they’re syndicated out to institutional investors. Mutual funds can also buy them in that situation.

In terms of how they differ from bonds, the bank loans that we look at are floating-rate, so I think we’ll talk about that in a little bit more detail later. They are higher in the capital structure than a high-yield bond would be. If you have high-yield bonds and bank loans with the same company and there is some kind of problem, such as a default, you’re typically going to see higher recovery rates, a better investor experience, in the bank-loan part of the capital structure.

Benz: Tim, let’s talk about when companies will want to go out and seek a bank loan. What type of company would do that, and why?

Tim Strauts: I think the biggest example we see is in the leveraged-buyout area, where we see mergers and acquisitions. You see a private equity firm buy out a company, and they add lots of debt to that company. That debt often times is actually a bank loan, and so the reason they do it is because it's relatively low-cost financing. [Because it has a] floating rate, you may think that could be a bad thing for the issuer, they're not intending to have this bank loan out there for 10 years. It's meant to be a few years, and oftentimes you’re going to have lower rates than you could offer in fixed-rate debt. Typically it’s the leverage buyouts or just any other distressed company that’s looking for financing and maybe doesn't want to pay the higher fixed rates that a fixed-rate bond would cost.

Benz: Sarah, when you look across sectors, do you notice that bank-loan issuance tends to cluster in any certain sectors, or is it pretty well-dispersed across industries?

Bush: Yes, you see a lot of disbursal across industries. Health care is a big industry that we see bank-loan issuance in, but I think that’s 10% or 11% of the market. Services is another area that you see a fair amount of issuance.

Benz: I’d like to drill in a little bit on the floating-rate nature of these loans because I think that has been a huge attraction for investors in the current environment. They're worried about the prospect of rising yields and what that could mean for conventional bonds. Let’s talk about how bank loans act in various interest-rate environments. How do their interest rates actually adjust, Tim, from a logistical standpoint?

Strauts: The rate you get on a bank loan is based off of LIBOR rates, and the LIBOR rate has been in the press a lot. There was some talk about fixing of the rate …

Benz: There was a scandal. I think sometimes people hear LIBOR and think, should I be nervous about any instrument that’s sort of hitched to LIBOR.

Strauts: But regardless of the scandal, the rate is just a short-term money market rate essentially. These loans are based off of that, so it’s LIBOR plus something, like LIBOR plus 1%, LIBOR plus 3%. The size of the plus is based off of the credit quality of the issuer. As interest rates rise, the LIBOR rate will rise, too, because it’s a short-term rate, and as the LIBOR rate rises, bank-loan rates rise with that. The reset levels depend on the loan, 30 to 90 days is the typical type of reset you tend to see. When you look at a bank-loan fund, you’re looking at a fund that has essentially very close to zero duration, so it almost has no interest-rate risk. The risk you’re really taking with bank loans is the credit risk because you’re getting companies with low-investment-grade credit ratings.

Benz: That was something, Sarah, we saw on display during the 2008 environment, where some bank loans had terrible losses; bank-loan funds certainly had terrible losses. Let’s discuss that credit sensitivity a little bit more. Why do bank loans tend to be so sensitive to the economic cycle?

Bush: Again, just to review what they are, you’re lending to companies that are taking on a fair amount of leverage. So there is a lot of overlap with issuers in the high-yield markets. Even though you’re going to get better recovery rates, you’re still taking on that kind of credit risk and the risk of default, which means when you have big credits sell-offs, this is an area that can really get hurt. We always talk about 2008, and that was an extraordinary environment. Bank-loan funds were down something like 30%. But even more recently in the third quarter of 2011, when we had all the instability in the markets, in August of 2011, the average bank-loan fund lost 4%. That’s sort of a gut check, I think, for people who are thinking about this category.